Applying the Cost Plus Method
The pure cost-plus method is a method used to determine the sales price of a product or service between associated parties. As such, its aim is to determine a gross profit mark-up.
However, in some circumstances the aim of the cost-plus method is to determine the company’s net profit. In such a scenario, the correct name of the method is the transactional net profit margin method (‘TNMM’) with a cost plus as a profit indicator. Marie-Lise Swinne, Corporate Tax Partner at Tax Consult in Belgium and Head of Alliott Group’s recently launched Transfer Pricing Services Group, explains how this complex international tax concept applies in practical terms.
In both cases, despite the level of mark-up applied, attention should be given to how the cost base is determined. While this is very familiar to some companies applying a true or pure cost plus method, it is often ignored by others.
Fully loaded costs are often used when applying a cost-based transactional net margin method.
In practice, multinationals and group companies tend to include all operational costs linked to the provision of their services and simply apply a mark-up on those costs when what they should be doing is excluding shareholder costs and/or pass-through costs. During a tax audit, this could quite clearly, trigger questions from the tax authorities!
The question can thus arise whether it is acceptable, and to what extent, to treat a significant portion of the taxpayer’s costs at arm’s length as pass-through costs to which no profit element is attributed or as shareholder costs.
The quantitative and qualitative content of a ‘cost pool’ will typically give cause for concern- all appropriate costs should be within the pool and all inappropriate costs excluded i.e. disbursement / pass-through costs and shareholder costs.
Pass-through costs are expenses that are initially paid by the service provider but which are generally passed on separately to the recipient, for example third party services such as the purchase of advertising space on behalf of group members. Although these external expenses relate to the functions performed by the provider, they do not warrant any additional remuneration as there is no question of any added value being generated by the service provider (neither performs any significant functions nor assumes any risks).
These costs are related to the functions carried out by the service provider, but apart from passing these costs on, they do not justify remuneration. Whether costs are involved in such cases generally hinges on whether an independent entity would not charge a profit margin on passing on such costs. The response should not be based on the classification of these costs as ‘internal’ or ‘external’ costs.
Shareholder costs are the costs incurred for the provision of shareholder activity. The OECD Guidelines (July 2017, paragraph 7.10) define shareholder activity as:
“an intra-group activity that may be performed relating to group members even though those group members do not need the activity (and would not be willing to pay for it were they independent enterprises). Such an activity would be one that a group member (usually the parent company or a regional holding company) performs solely because of its ownership interest in one or more other group members, i.e. in its capacity as shareholder. This type of activity would not be considered to be an intragroup service, and thus would not justify a charge to other group members. Instead, the costs associated with this type of activity should be borne and allocated at the level of the shareholder. This type of activity may be referred to as a ‘shareholder activity.”
Shareholder costs include, for example, those costs related to:
- Shareholder meetings
- Reporting requirements (consolidation of reports)
- Preparation of the consolidated financial statements.
The aforementioned costs should be excluded from the cost base. However, one can see that their identification is subject to discussion/interpretation. As with many issues, nothing is ever black and white!
Correct analysis of the cost base will minimise the provider’s profit – from the group’s perspective, this will be attractive as it will allow the impact of a high mark-up to be reduced when required and will reduce the risk for the paying company in the event of a tax audit.
For these reasons, we strongly recommend a regular review of your cost plus method with your tax advisers. This is essential in the post-BEPS environment!